Capital Financing For Independent Schools
A Primer for School Boards and Management
INTRODUCTION
The continued growth in demand for private school education is a result of a number of factors.
The most significant have been (1) the persistent growth in population of grammar and high
school age children relative to the number and capacity of private schools, (2) widespread
dissatisfaction with public school education, (3) need or desire for specialized education in the
curriculum, (4) need or desire for better quality teachers, a lower student-to-teacher ratio and
increased one-on-one attention between teachers and students and (5) conviction that a particular
private school offers a better combination of academics, athletics, extracurricular activities and
values building than the alternatives.
Public elementary and secondary schools in the United States are largely supported by tax dollars
collected by states and local governments or school districts and the planning, development and
financing of public school facilities tend to be done on a highly centralized basis. In contrast,
private schools rely primarily on tuition revenue, charitable donations and endowment and
investment portfolio income to support their operations, and each school is on its own to address
its facility and financing needs. To address new or evolving facility requirements, private schools
lacking all of the required funds to address such needs have turned increasingly to debt financing
over the past decade. Moreover, following the lead of colleges and universities, private schools
have been using tax-exempt financing in recent years with greater frequency.
This paper seeks to provide a basic overview of the key issues, considerations and options
associated with the use of debt by private schools to address facility financing needs. In addition,
for a school which has decided to pursue debt financing, it provides basic guidelines for the
choice of debt modality and structure depending on that school’s finances, type and amount of
financing sought and the financial environment at the time of the planned borrowing.
FUNDING ALTERNATIVES
Private schools require working capital to fund routine operating costs such as teacher and
administrator salaries and benefits, academic and athletic programs, utilities, repair and
maintenance, printing, copying and office supplies, IT supplies, software and services, student
transportation and the like. The sources of such working capital are typically tuition, auxiliary
fees and revenues, development dollars and investment income.
When private schools face the need for a major new facility, renovations to an existing facility or
other major capital expenditures, some schools, but not many, have the option to fund such costs
from cash reserves, endowment funds or contemporaneous gifts. More frequently, in lieu of
deferring the project, schools turn to debt financing.
Debt financing offers the borrower the opportunity to fund a project on a near term basis while
spreading the cost of that capital over time in order to meet budgetary and affordability
constraints. In addition, long term debt enables the school to effectively pass the cost of the
capital investment to the users of the associated project over its useful life.
Traditionally, independent schools had avoided debt financing, electing to defer facility
acquisitions or improvements until the requisite funds were raised through a capital campaign
and gifts. To the extent that such schools borrowed at all, their debt financings were structured
as conventional commercial loans from a bank. However, in recent years, there has been a
convergence of trends and events which has resulted in increased and more aggressive borrowing
activity by private schools:
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Demographics1: Over the past 10 years, the number of private schools operating in the
U.S. has increased by nearly 3,300 from 25,998 in the 1991-92 school year to 29,273 in
the fall of 2001. Total private school enrollment at the end of 2001 was over 5.3 million,
representing approximately 10% of total (public and private) elementary and secondary
enrollment in the United States. Since the 1991-92 school year, private school enrollment
has increased by over 450,000 students or 9.24% from 4,889,545 in 1991-92 to 5,341,513
in the fall of 2001. The following table provides summary statistics on the number of
private schools operating in the U.S. and private school enrollment between 1991 and
2001.
Schools
Total
% Growth
Elementary
Secondary
Combined
1991
1993
1995
1997
1999
2001
25,998
-2.67%
15,716
2.475
7,807
26,093
0.37%
15,571
2,506
8,016
27,686
6.11%
16,744
2,533
8,409
27,402
-1.03%
16,623
2,487
8,292
27,223
-0.65%
16,530
2,538
8,155
29,273
7.53%
17,427
2,704
9,142
1
All statistical data provided by the National Center for Education Statistics; 2002-2003 data will be available in
Q3, 2005.
2
Enrollment
Total
% Growth
Elementary
Secondary
Combined
1991
1993
1995
1997
1999
2001
4,889,545
1.06%
2,766,059
818,570
1,304,917
4,836,442
-1.09%
2,759,771
791,235
1,285,437
5,032,200
4.05%
2,835,247
811,422
1,385,531
5,076,119
0.87%
2,824,844
798,339
1,452,937
5,162,684
1.71%
2,831,372
806,639
1,524,673
5,341,513
3.46%
2,883,010
835,328
1,623,175
The National Center for Education Statistics projects a cumulative increase in private
elementary and secondary enrollment of 7% between 2001 and 2013. No information is
available as to the projected number of private schools in the U.S. over that same
timeframe, but recent rends suggest that there will be significant net growth.
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Facility Expectations: Parents and students have become more “consumer-driven”
when it comes to the facilities and resources of their private schools. The result has been
increased demand for, among others, modern athletic and multi-purpose facilities; stateof-the-art science labs; higher quality residential and dining facilities and sophisticated
information technology infrastructures.
ƒ
Capital Markets Flexibility: Over the past 20 years, the debt markets have expanded
appreciably and undergone a revolution of creativity. Today, they offer a broad array of
financing techniques and options to the institutional borrower. Over the same
timeframe, major underwriters and lenders have developed “industry expertise” in the
educational sector and now can offer highly customized and affordable solutions to the
financing needs of each borrower.
ƒ
More Sophisticated Management: The boards and management of private schools
have likewise become more sophisticated with regard to financial matters. Dynamic
analytical tools, reference private school financing activity, readily available statistical data
and practical business experience have enabled school boards and management to take a
more scientific approach to weighing the costs and benefits of a financing and a proposed
financing structure. For instance, a number of schools with considerable cash reserves
and endowments have never the less undertaken debt convinced that they can realize
investment returns on their endowment capital at meaningfully higher levels than the
interest cost of such debt financing, particularly if the debt is tax-exempt.
There is limited data available on private debt financing by independent schools. However, the
data regarding public financings (that is, bond issues sold in the public capital markets) indicates
that private schools have embraced debt financing as an important tool for advancing their
missions. Approximately 70 private schools in the U.S. have issued bonds with published credit
ratings2. In addition, one of the major rating agencies estimates that for every one school that has
issued bonds based on its own credit rating, five more have conducted bond financings
supported by a direct-pay letter of credit from a bank or bond insurance provided by a U.S. based
bond insurance company.
2
Moody’s Investors Service; Fitch Investors Service; Standard & Poor’s Corporation
3
The continued growth in demand for private school education, the growing and evolving facility
needs of private schools and their students and increasingly accommodating capital markets
indicate that the number and amount of such debt financing will likely continue to increase.
4
TYPES
OF
DEBT
Debt can be categorized in a number of ways based upon its term, interest rate modality, security
structure and manner of placement or sale. The traditional bank loan now must compete with a
number of more sophisticated and often less expensive types of debt. Perhaps the two most
important developments in the debt marketplace for private schools over the past twenty years
have been “tax-exempt” financing and variable interest rate structures. Both have served to
lower significantly the cost of capital to private schools versus the traditional fixed rate bank loan.
In addition, such techniques are being augmented with increased frequency with derivative
financial products (interest rate swaps, caps, collars) to design highly customized solutions to the
needs and judgments of particular borrowers. In fact, the “creative financing” structures have
become so prevalent and risk profiles and funding techniques at banks have so evolved that some
banks no longer even offer the “traditional” long term fixed rate loan structure. The table below
attempts to organize and categorize the types of debt available to private schools today by
defining features:
Manner of Placement or Sale
Private Placement
ƒ Bank or single
institutional investor
ƒ Typically styled as a
“loan”
ƒ Investor owns loan to
maturity or repayment
Public Offering
ƒ Loan is securitized into
publicly traded bonds
ƒ Multiple individual
and/or institutional
investors
ƒ Secondary market for
bonds enables investors
to sell investment before
maturity. In contrast to
privately placed debt,
investors will accept a
lower rate in exchange
for secondary market
liquidity.
Taxability of Interest Income
to Investor
Taxable
ƒ Investor liable for
income tax on interest
ƒ Taxable debt interest
rates driven by yields on
U.S. Treasury securities
Tax-Exempt
ƒ Interest income is
exempt from federal and
sometimes state and
local income taxation
ƒ Investors will accept a
lower rate based upon
effective “after-tax” yield
on comparable taxable
debt
ƒ Result: Borrowers are
able to reduce interest
cost from 1 to 2.5% by
borrowing tax-exempt
versus taxable
5
Interest Rate Modality
Fixed
ƒ Rate(s) based upon
positively sloped yield
curve (ie. rates typically
increase as term of debt
lengthens)
ƒ Rate is fixed for a
specific duration usually
to the maturity date of
the obligation
ƒ Rate is based on credit
quality of borrower
Variable
ƒ Rate based upon short
end of yield curve (ie.
tend to be lower than
long term fixed rates,
although subject to
vagaries of economy
over time)
ƒ Rate adjusts daily,
weekly, monthly and
based upon an index or
reset based upon general
market conditions
ƒ If a variable rate bond,
rate is also based on
credit quality of letter of
credit bank
Term
Short Term
ƒ Usually five years or less
ƒ Typically, no principal
amortization. Entire
principal amount
repayable at maturity
ƒ Usually styled as
“Notes” if sold publicly
Long Term
ƒ Typically ten years or
longer
ƒ Principal generally
amortizes fully over term
of debt
ƒ Usually styled as
“Bonds” if sold publicly
Credit Structure
General Obligation
ƒ Unsecured unconditional
guaranty based upon
overall financial strength
of borrower
Revenue Bond
ƒ Debt secured by
combination of net
revenues of school and
security interest in select
or all tangible assets and
funds
ƒ Typically augmented by
the school’s general
obligation
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KEY DEBT FINANCING CONSIDERATIONS
The private school faces a number of considerations in deciding to borrow and then determining
the type and amount of debt financing that best meets its needs and constraints. Major
considerations, along with some relevant commentary, include the following:
ƒ
Amount and Purpose of Borrowing: Small borrowings for projects or general working
capital needs are best structured as bank loans or revolving lines of credit. As discussed
at greater length in forthcoming sections, working capital is generally not a qualified
purpose for tax-exempt financings. In addition, the transaction costs for tax-exempt
transactions tend to be higher than those of comparably sized taxable financings.
Consequently, for smaller transactions, any interest cost benefit of a tax-exempt financing
is often negated by such higher transaction costs. As a general rule, a school undertaking
a direct borrowing of $3 million or less is best served going to a bank rather than the
capital markets. Banks are the best resource for such financings and such transactions
can be integrated readily with other services (depository, checking, cash investment
management) provided by the bank.
The advantages of borrowing in the capital markets in terms of lower interest cost and
structuring flexibility become significant for transactions of $5 million or more,
particularly if the debt is tax-exempt. Larger borrowings tend to be for “hard” assets
such as land, buildings and equipment which qualify for such debt.
ƒ
School’s Financial Resources: Debt capacity and the structure and cost of specific
debt will be defined and limited to a large extent by the historic financial performance
and current financial resources of the school. The primary evidence of such performance
and resources is the school’s financial statements. Such factors as balance sheet strength,
debt service coverage ratios, fundraising success and investment portfolio performance
are significant. For borrowers undertaking relatively large financings, the more
accommodating lenders and investors will give weight to (1) financial projections
depicting future levels of net income adequate to service the proposed debt and (2) a
large capital campaign which is meeting its milestones in terms of pledge amounts and
collections.
ƒ
Market Demographics and School Market Position: Strong demographics and
demonstrated sustained demand for private school education in the borrower’s “market
area” is a major lending and investing consideration. Of equal importance is the school’s
success in its market at consistently attracting students at its tuition “price points” and
maintaining respectable matriculation and college admissions statistics.
ƒ
Quality of Management and Education: The collective level of engagement by
parents, board members and senior management in the school’s finances and borrowing
activity is a key indicator of financial and operational stability and breadth of community
and “stakeholder” support. Decision making processes which reflect robust planning and
analysis, vigilant monitoring and well-coordinated communications among the various
stakeholders is important. Equally important is management depth in numbers and in
relevant expertise and experience. The relative success of the school in addressing its
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mission can be readily measured by considering matriculation rates, student turnover
rates, and in the case of high schools, SAT scores and percentage of graduates
progressing to college.
8
TAX-EXEMPT FINANCING
The tax-exempt bond market is unique to the United States. Its creation was and the combined
result of the U.S. Constitution which recognizes certain special rights of each of the United States
and the U.S. tax laws which, pursuant to the Constitution, exempt from income taxation the
interest income on obligations issued by state and local governments or governmental entities.
Until the mid-1960s, the tax-exempt bond market was almost entirely the province of
governmental borrowers. However, amendments to, and more liberal interpretations of, the
Internal Revenue Code combined with the ingenuity and drive of capital market intermediaries
and bond attorneys have expanded access to tax-exempt financing to other types of borrowers
than governments. One such type of borrower is the non-profit institution qualified under IRS
Section 501(c)(3). As a result of the growth in the national economy and the broader deployment
of tax-exempt financing, total annual dollar volume of public tax-exempt debt has grown from
$55 billion in 1980 to over $350 billion in 2004.3
Relative to the taxable debt market, the tax-exempt bond market has proven to be not only a
source of lower cost capital but a provider of capital on more favorable terms. Tax-exempt debt
can be issued readily on a long term (20 to 30 years) fixed rate basis. In contrast, most taxable
debt financings, other than very large issues for investment grade rated borrowers, are more
typically structured with a floating rate and a shorter term. In addition, the financial covenants of
tax-exempt debt tend to be less restrictive than those of taxable debt. Such covenants relate to
liquidity requirements, minimum acceptable debt service coverage levels, issuance of additional
debt and the disposition of surplus capital and assets. The tax-exempt market’s legacy of more
lenient terms is in no small part due to the prudent and conservative nature of its most prevalent
borrowers – governments, agencies, authorities and non-profit institutions. There is some price
to be paid by the borrower in exchange for access to lower cost financing on more favorable
terms. That price comes in the form of transaction costs which are often higher than those of
taxable transactions. However, generally, the long term cost savings from a tax-exempt issue
significantly exceed the incremental transaction costs. Moreover, a significant amount of the
transaction costs can be funded with tax-exempt proceeds and thereby amortized over the term
of the financing. The majority of transaction costs relate to the services of the financial
intermediaries and professional services firms (various legal counsel, financial advisor) involved in
the transaction. The complexities of the tax laws and certain financing techniques generally
require more legal research and documentation, quantitative analysis and evaluation and financial
structuring in order to achieve an optimal financing solution.
The description that follows regarding “eligible” borrowers, eligible uses of tax-exempt bond
proceeds and the unique issues associated with religiously affiliated schools will provide a flavor
of the complexities to be navigated by the private school borrower in a tax-exempt transaction.
1. Eligible Borrowers
Generally, only state and local governments, agencies or authorities can issue tax-exempt
bonds. However, a non-profit corporation can access the tax-exempt market by having
3
Sources: The Bond Market Association and The Bond Buyer, January 3, 2005.
9
such a governmental entity issue bonds “on behalf of” the non-profit and then lend the
proceeds to the non-profit as borrower. In such cases, the entity issuing the bonds is said
to be serving in a “conduit” capacity and has no direct repayment obligation with respect
to the bonds.
To qualify for tax-exempt financing, the non-profit borrower must be a “501(c)(3)
corporation”. In order to be a “501(c)(3)”, the institution must be organized and
operated for a religious, charitable, scientific, educational or related purpose. That
assessment is made by the Internal Revenue Service pursuant to an application and
review process. If that process is favorable, the IRS issues a “determination letter” that
the borrower qualifies. Examples of non-profit educational organizations include private
colleges and universities, private elementary and high schools, research institutions and
special purpose foundations supporting such organizations. Colleges and universities
were among the earliest type of non-profit to source capital in the tax-exempt markets. It
was not until the early 1990s that private K-12 schools began to follow suit.
Tax-exempt bond issues by independent schools cover a broad
spectrum of size, credit quality and location
œ From AAA-Rated (St. Paul’s School – New Hampshire) to Baa3-Rated
(Oakwood School – California)
œ From $4.46 million (Green Acres School – Maryland) to $44.635 million
(Brunswick School – Connecticut)
œ Private school bond issues have been completed in virtually every state in the
U.S. The states in which the largest number of rated bond issues have been
completed are4:
3 Massachusetts
3 New Hampshire
3 Connecticut
3 Virginia
3 New York
3 New Jersey
2. Eligible Uses of Tax-Exempt Bond Proceeds
There are five basic categories of expenditures eligible for tax-exempt debt, each with its
own unique limitations under the tax laws:
ƒ
4
“Project” Costs: The primary costs associated with any financing are, of course,
those of the “project” itself. The project can include the acquisition or
construction of land, buildings, equipment and related infrastructure. Such assets
must be owned directly by the borrower (or an affiliated non-profit entity such as
a foundation or alumni association) and used primarily for the non-profit’s
mission as opposed to an unrelated business activity. The cost of the assets can
include certain soft costs such as engineering, architectural, legal and brokerage
fees. As is almost consistently the case with any general limitation in the laws
applicable to tax-exempt finance, there are “de-minimis” exceptions. For
instance, up to five percent of the proceeds of a tax-exempt financing can be used
for otherwise prohibited purposes (characterized by bond attorneys as the “bad
Moody’s Investors Service.
10
money” exception) such as working capital, certain facilities used for profit
making enterprises and financing costs in excess of two percent.
ƒ
Prior Debt: As long as the proceeds of outstanding taxable debt were spent on
eligible project costs, proceeds of a tax-exempt issue may be used to refinance
such debt. Likewise, a tax-exempt issue can be used to refinance a prior taxexempt issue. However, it can often be the case that the prior tax-exempt issue is
a fixed rate transaction which is “call protected”, that is, not subject to immediate
repayment. In such instances, the tax-exempt refinancing must be structured as
an “advance refunding” of the prior issue. The tax laws allow non-profits only
one advance refunding for the specific projects earlier financed.
ƒ
Reimbursement: It is not uncommon for a private school to spend capital on
the initial or preliminary costs of a project with the expectation of financing the
majority, if not all, of that project’s cost with tax-exempt bonds. Federal tax
regulations impose a general prohibition on reimbursement to the school of such
expenditures from bond proceeds. However, they also provide a series of
exceptions which in most instances should enable a school in a properly
organized financing effort to secure reimbursement. Those exceptions are as
follows:
–
If prior expenditures were funded with proceeds of a loan still
outstanding at the time of the tax-exempt issue, such expenditures
may be repaid, as described above in “Prior Debt”.
–
Select “soft costs” paid prior to the commencement of acquisition or
construction of a project may be reimbursed to the extent of 20% of
the issue price of the bonds. Soft costs could include, for instance,
architectural, engineering, and similar professional services, but not
the actual costs of land acquisition or construction.
–
Any other capital expenditures including costs of issuance paid before
issuance of the tax-exempt bonds may be reimbursed, but only if
“Official Intent”, typically through the adoption of a “Reimbursement
Resolution”, has been established by the school’s board. Any such
costs incurred more than 60 days before adoption of such a resolution
will not qualify. This rule is an unfortunate trap for unwary and
uninformed schools which advanced funds in anticipation of an
eventual tax-exempt issue. Compliance through adoption of a
properly crafted Reimbursement Resolution is a simple and
inexpensive undertaking which in no way binds the school to the
project or bond financing unless it determines subsequently to
proceed with the project. There is one additional limitation on
reimbursement of this category of capital expenditure.
The
reimbursement must occur no later than 18 months after the later of
(1) the date the original expense is incurred or (2) the date that the
project is placed in service, but in no event more than three years after
11
the expense is incurred. Interestingly, for schools involved in major
facility developments and incurring considerable costs in advance of a
planned tax-exempt financing, the best way to assure that early costs
can be reimbursed may be by borrowing such costs under a line of
credit facility, then repaying the borrowed funds with the proceeds of
the tax-exempt bond issue.
Because reimbursed funds are considered “spent”, the school may apply or invest
such funds however it sees fit without further limitation under the tax code
provisions governing bond proceeds.
ƒ
Working Capital: The practical effect of federal tax regulations on the use of
tax-exempt bond proceeds for working capital is to limit the amount of such
working capital to 5% of the principal amount of the bonds less any reserves,
provided that such working capital is to be used in connection with the project
being financed.
ƒ
Select Other Costs: The nature and complexity of most school financings are
such that various other costs must be incurred. Those include costs of issuance,
capitalized interest and a debt service reserve fund. Costs of Issuance typically
include all costs incurred directly to facilitate the financing including underwriting
and bank fees, rating agency fees, and legal and financial advisory fees (but not
the cost of credit enhancement). Up to two percent of the principal amount of
the bond issue may be spent on costs of issuance. Any additional costs must be
funded with borrower cash or the proceeds of a separate taxable financing.
Capitalized Interest is eligible for tax-exempt financing in an amount necessary to
fund interest during the period of construction and for up to one year thereafter.
Most private school tax-exempt bond issues are structured as revenue bonds and
the underwriters or banks require that the bond issue have a Debt Service Reserve
Fund as a first source of money in the event of the school’s failure to make a
timely payment of debt service. The federal tax laws limit the amount of the
Debt Service Reserve Fund to the lesser of 10% of the bond issue amounts,
125% of average annual debt service of the bonds or maximum annual debt
service.
3. Restrictions on Investment
As a general rule, the non-profit school may not profit by investing the proceeds of its
tax-exempt bonds at yields higher than the interest cost of such debt. Such profit, often
called “arbitrage income”, must be rebated to the U.S. Treasury Department or otherwise
avoided through yield restricted investments. There are several exceptions to this rule
which for the most part are of no or limited benefit to a private school transaction other
than the “reimbursement” exception noted above.
12
4. “Replacement” Proceeds
There is a corollary concept to the general prohibition of arbitrage of tax-exempt
proceeds. That rule applies to funds which are effectively “replaced” by tax-exempt
proceeds. Such funds comprise money that has been raised, segregated or earmarked
specifically to finance the same project to which the tax-exempt issue applies. In such an
instance, any income earned on such funds in excess of the borrowing cost of the
associated bond issue is likewise subject to rebate or yield restriction. This rule may
represent a significant imposition on such money. However, with proper advance
planning by a financial advisor and legal counsel, the problem of “replacement” proceeds
can be avoided or minimized. Part of such planning entails review of capital campaign
literature before publication and proposed Board resolutions and initiatives in each
instance to assure that existing or future collected funds are not so restricted in their
application as to give rise to the restriction.
5. Pledges, Fund Balance Requirements, Collateral
Often, to assure the feasibility of a transaction or to lower its cost of capital, a private
school will consider some or all of the following techniques to further secure proposed
debt:
ƒ
Pledging a portion of its endowment
ƒ
Agreeing to maintain fund balances above a minimum required level
ƒ
Securing collateral from a third party (eg. a donor or foundation) such as
securities or bank accounts
Without appropriate structuring of such terms, the yield on such funds will be effectively
restricted to the school’s associated borrowing cost. Again, creative advance planning
with the assistance of knowledgeable professionals can help a school navigate such tax
law pitfalls while achieving its desired objectives.
6. Special Rules – “For Profit Activities”
The IRS has crafted a series of complex rules designed to curtail, and define the
permissible scope of, involvement by private enterprise in tax-exempt borrowings as well
as the operations by non-profits of “for-profit” endeavors in tax-exempt financed
facilities. Still, there are various legitimate circumstances under which private enterprise
can or must become involved with a private school in connection with the development
or management of a school or certain elements of its operations. Examples include the
following:
ƒ
A developer undertaking a design-finance-build agreement with a non-profit
school for the development of school facilities.
13
ƒ
A for-profit education services company providing turnkey management of a
non-profit private or charter school.
ƒ
Private companies operating the private school cafeteria, bookstore, parking lot or
other on-campus enterprises, and in that connection, possibly leasing school
facilities and space.
ƒ
The operation in a tax-exempt financed facility of a summer camp, private social
functions or other for-profit ventures not directly related to the school’s nonprofit mission.
The following is a brief summary of applicable rules. However, each school is advised to
consult with experienced legal counsel regarding the application of relevant tax laws to its
proposed endeavor to assure compliance and avoid compromising the tax-exempt status
of an outstanding or forthcoming bond issue.
ƒ
Private Use Rules: In general, federal tax law disallows the use of tax-exempt
bonds to finance facilities which are unrelated to the school’s mission or which
are reasonably expected to be used consistently for “for-profit” endeavors.
Consequently, a private school can not, for instance, develop a shopping center or
commercial office building on school land with the proceeds of a tax-exempt
financing. In addition, a school must be vigilant not to engage in excessive forprofit enterprise in traditional school facilities already financed with tax-exempt
bonds. There are “de minimis” exceptions to the rule which generally enable
schools to conduct legitimate ancillary activities on campus such as a cafeteria,
bookstore or convenience store.
ƒ
Management Contracts: There are specific rules which govern the legal and
financial relationship between private management companies and non-profit taxexempt borrowers. Those rules specifically limit the term of, and compensation
structure under, such agreements.
7. Special Considerations – Religiously Affiliated Schools
Private schools which are religiously affiliated must navigate some additional laws in
connection with a tax-exempt borrowing. Those laws comprise the First Amendment of
the U.S. Constitution relating to the establishment of religion, similar provisions in the
constitutions of the state in which the school is located and the evolving body of case law
interpreting those constitutional provisions. As a general matter, the relevant case law in
recent years has taken a decidedly liberal turn with the result that most religiously
affiliated schools have little difficulty using tax-exempt debt in the same manner as their
non-sectarian counterparts. The following are general factors upon which bond counsel
rely in evaluating a candidate school and the purpose of its financing:
ƒ
the neutrality of the law or program (ie. does the law treat all borrowers the same
regardless of religious affiliation?)
14
ƒ
the nature of the aid (ie. are the bonds being used for secular as opposed to
primarily religiously oriented facilities, such as a chapel?)
ƒ
the nature of the activities conducted on campus and the recipients of the
assistance (schools which conduct primarily religious activities, as opposed to an
academic program, for students of uniformly one faith are likely not going to be
eligible for a tax-exempt financing)
ƒ
the nature of the borrower (schools which discriminate in their admissions policy
based upon religious affiliation likewise will probably not qualify)
ƒ
the extent to which there are other fundamental rights which must be reconciled.
Provided that a religiously affiliated school and its policies, programs and activities pass
bond counsel analysis, the only practical limitations on tax-exempt bonds is that the
proceeds cannot be spent on a building used for religious worship or primarily for
religious training.
8. Creative Applications of Tax-Exempt Finance
The combination of relatively lower interest rates available in the tax-exempt bond
market and a wealth of financing structures and techniques offer private schools
opportunity to craft highly customized transactions. Those transactions can be designed
with reference to such considerations as:
ƒ
attempting to achieve the lowest possible interest cost over a specific timeframe,
ƒ
tailoring debt service to specific near term budgetary constraints or longer term
financial projections and objectives,
ƒ
enabling the school to maintain higher degrees of liquidity by conserving cash that
might otherwise have to be spent on project costs, and
ƒ
likewise enabling the school to maintain investments in endowments or reserves
that might otherwise have to be liquidated to fund project costs.
With respect to both short term and long term investments in the school’s portfolio,
there are a number of interesting strategies to deploy fixed income investments as (1)
“hedges” against adverse interest rate movement or (2) effectively as a resource to
subsidize the payment of debt service while invested at yields higher than the interest cost
of the borrowing. Generally, any calculation of the compounded return available from
long term investments in balanced accounts versus the cost over a similar term of a taxexempt transaction serves as a compelling argument for a school to leverage its balance
sheet and hedge the debt with its financial assets.
There are significant benefits associated with both fixed rate borrowing and variable rate
financing with tax-exempt obligations. Fixed rates, particularly in recent times, have been
available at low or near low 30 year levels. The combination of rates which are as much
15
as 200 basis points lower than taxable rates and the ability to amortize such debt over as
much as 30 years offers schools the opportunity to secure significant amounts of debt in
the capital markets (much more than available from banks) on an affordable basis. Many
schools have opted for variable rate demand bond (VRDB) financing over fixed rate
obligations out of conviction that VRDBs offer the potential for a lower average cost of
borrowing and greater future financial flexibility (ability to repay debt at par, to refinance
more readily or to borrow additional funds more easily).
9. Financing Process and Structures
The timetable for a project and its tax-exempt bond issue can be as short as 90 days or
run over several years depending upon the size and complexity of the project and
financing and the school’s finances. The following sample timetable is indicative of the
various elements, timing and required coordination in a bond issue.
16
Sample Financing Timetable
Month:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
Preliminary Planning Phase
Project Scope Development
Reimbursement Resolution and Board
Approval for Project
Preliminary Design/Engineering/Land
Use Planning
Internal Feasibility and Debt Capacity
Analysis
Development Phase
Final Design (Plans & Specs)
Bid Package Development
Construction Bid/Contract
Negotiations
Permitting – Land/Environment/ Bldg.
Finance Plan Determination
Financial Model/Financial Projections
Assessment of Financing Options
Competitive Financing Selection
Process
Bond Issuing Authority Approval
Process
TEFRA Hearing
Inducement Resolution
Other Local Government Approvals
Transaction Structuring
Determination of Security Structure
Transaction Documentation and
Development of Preliminary Official
Statement
Credit Rating Process
Transaction Execution
Marketing and Pricing of Securities
Competitive Bidding of Investment of
Proceeds Derivative Products
Closing and Delivery of Securities
A. Preliminary Planning
A thorough analysis of a private school’s operating and facility needs and
constraints as well as its financial resources is a key first step in establishing the
feasibility and utility of debt financing for the school. The extent of that exercise
can vary widely depending upon numerous factors including the age and size of
the school, the size and condition of its grounds and facilities, specific facility
needs and the school’s financial condition and capital fundraising program. The
school is well served to develop and maintain a Strategic Plan, a Facilities Plan
and a Financial Plan.
17
18
ƒ
The Strategic Plan relates to the school’s operations, finances, facility
requirements and mission and goals. It addresses the school’s
objectives in multiple respects – organizational, academic,
extracurricular, financial, facility-wise, community-wise – and lays out a
plan of action for achieving those objectives. It also helps to assure
consensus among the school’s key stakeholders with respect to the
strategic direction of the school.
ƒ
The Facilities Plan (or capital improvement program) describes the
existing facilities of the school; identifies maintenance, expansion and
new facility needs and projects and prioritizes those projects based upon
such factors as health, safety, regulations, academic importance, cost
and competing schools.
ƒ
The school’s Finance Plan details the manner in which the school intends
to fund planned facility development, acquisition, renovation or
expansion. It describes the estimated timing and cost of the projects
and the proposed sources of capital to fund those costs. Generally,
debt financing is a major form of such capital. The Finance Plan should
relate the school’s current and projected finances to such debt in order
to demonstrate the key conditions to continued financial stability. This
can be done most effectively through the development of a financial
model which reflects historical and projected revenues, operating
expenses and debt service and which depicts key financial ratios on
prospective financing. In short, the financial model can help the
school’s management and board determine the school’s debt capacity,
future debt affordability and important conditions underlying continued
financial stability.
An independent financial advisor can help a school’s management and board to
organize and analyze financial data, projections, project priorities and costs and
then develop a coherent and feasible Finance Plan. For a real estate project, the
financial analysis and planning process can be conducted in tandem with other
elements of the overall project development process such as preliminary design
and engineering, legal and capital campaign program. As with the school’s
Strategic Plan, the process associated with the development of the Finance Plan,
if conducted properly, is an ideal way to help assure stakeholder consensus and
for approved projects, support for the forthcoming financing effort.
B. Transaction Planning
Once specific projects have been identified, a finance plan for those projects has
been developed, and the project timetable indicates the upcoming need for
funding, the next step for a school is to launch a transaction planning process. In
light of the multitude of potential sources of capital, and capital financing
structures and techniques, a financial advisor can play a helpful role in developing
18
and conducting a process for helping the school to evaluate and choose among
alternatives. Specific elements of such a process should including the following:
ƒ
Finance Plan: The Finance Plan should be finalized. It should identify a
specific preferred financing amount, structure and timetable or financing
scenarios under consideration. It should include analysis from the
school’s financial model which demonstrates the school’s ability to service
the proposed debt. The model should include a breakdown of revenues
by sources and expenses by component with a narrative that explains the
underlying assumptions and basis for those assumptions. A financial
advisor can plan a particularly helpful role in developing the financial
model, running various financing scenarios and helping to assure realism
in the development of the school’s “Base Case” financial projections.
ƒ
Legal Consultation: The private school is well served involving
qualified legal counsel in its project planning process at an early stage.
Counsel can play an integral role in addressing the array of real estate,
contract, regulatory and tax issues that typically arise with a new capital
project. Of particular importance will be those issues unique to taxexempt bond financing which must be navigated – the school’s eligibility,
the eligibility of the project and the governmental issuer approval process.
Although the school’s counsel can play a helpful role in preliminarily
analyzing such matters, those matters will ultimately have to be addressed
by “Bond Counsel”, an independent law firm which will provide a legal
opinion that the bonds are enforceable obligations of the school and that
their interest is exempt from income taxation. Early consultation by the
school with its legal counsel (“Borrower’s Counsel”) and the bond
counsel firm of the issuing government or authority for the school’s
prospective bond issue can help assure that the school does not run afoul
of important rules (eg. reimbursement, eligible cost) to its financial
detriment.
ƒ
Assessment of Financing Options: In concert with the development
of financial projections and a Finance Plan, the school should undertake
an assessment of its financing options. Under most circumstances for a
transaction of $5 million or more, tax-exempt financing will be the
superior financing alternative in terms of capital cost and legal provisions.
Other aspects of the transaction should be considered during this phase
including the debt’s term, interest rate modality, amortization structure
and security structure. The judgment and practical business experience of
management and the board should be brought to bear in determining a
structure or alternate structures which best address the school’s needs and
constraints.
ƒ
Competitive Selection Process: Once the school has determined its
preferred financing approach, it is well served conducting a competitive
procurement of the financing. Such an exercise will provide the basis for
19
an open and fair evaluation of financing candidates (investment banking
firms and/or commercial banks), their qualifications and capabilities and
any creative techniques or structures which may serve to optimize the
outcome of the financing. At the same time, such a process will engender
competitive pricing proposals for services and assurance of the basic
terms and provisions of the proposed transaction from the financing
candidates. Typically, such a process is initiated through the distribution
of a written request for proposals which requires a written response to
specific questions relevant to both the candidate’s qualifications as well as
the financing. Often the board or management will designate a finance
committee or chief financial officer to shepherd the procurement process.
The written proposals, often followed by interviews of those candidates
with the most favorable proposals, should provide the committee or
finance staff with the information reasonably necessary to make an
informed selection of both its financing source and type of financing.
The culmination of the transaction planning process should be the following:
ƒ
selection of a financing team,
ƒ
determination of a basic financing structure (fixed rate, variable rate or
combination), and
ƒ
verification of financing feasibility, cost and major terms.
With that, the school should be well prepared and positioned to proceed with the
actual development and execution of its financing.
The illustration below lists the key participants in a bond financing:
BORROWER
Attorneys
ƒ Bond Counsel
ƒ Borrower’s
Counsel
ƒ Underwriter’s
Counsel
ƒ Trustee’s
Counsel
ƒ Bank Counsel
(Lender, Letter
of Credit
Provider)
Financial
Intermediary
ƒ Issuer
ƒ Underwriter
(Public or
Private Sale)
ƒ Bank
(Loan)
ƒ Remarketing
Agent
(VRDBs)
Others
ƒ Accountants
ƒ Bond Trustee
ƒ Credit
Enhancers
– Bond Insurer
– Bank (Letter
of Credit
Provider)
ƒ Financial
Advisor
ƒ Rating Agencies
20
C. Financing Structures and Options
The phrases “financing structure” and “structuring a financing” relate to the
various elements of a transaction described earlier, namely:
(i)
(ii)
(iii)
(iv)
(v)
manner of placement or sale
taxability of interest income
interest rate modality
term and amortization structure, and
credit structure
Because the majority of debt financings undertaken by independent private
schools for facilities over the past decade have been (1) long term, (2) tax-exempt
and (3) revenue bonds, the discussion below focuses primarily on the basic
framework and structuring options for financings which combine those elements.
ƒ
Credit Structure: Only the most extraordinarily wealthy private
schools can look forward to a “general obligation” credit structure for
large, facility based financings. General obligation debt is backed only
by the school’s unconditional guaranty to pay. Investors’ and lenders’
willingness to accept such an unsecured guaranty would be based upon
the substantial financial resources of the school, as possibly further
evidenced by very high investment grade credit ratings.
There are instances in which financial institutions and capital markets
investors will accept a credit structure pursuant to which their security is
limited to (1) the project being financed and/or (2) other specific
collateral such as land, equipment, or financial investments. However,
such transactions tend only to be viable in cases when there is a very
low “loan to value” ratio and where the collateral is a crucial asset of the
school.
The most frequently used credit structure underlying a debt issue has
come to be characterized as the “revenue bond”. Typically, regardless
of the project(s) being financed, the school will pledge the following to
secure a revenue bond:
à
à
à
all of its “net revenues”
all of its real estate comprising its campus (secured by a
mortgage or dead of trust)
some or all of its personal property (furniture, fixtures and
equipment)
Depending on the school’s financial strength and the amount of the
transaction, banks and underwriters may seek the inclusion of one or
more of the following to additionally secure the financing:
21
à
à
à
the school’s general guaranty
a pledge of some or all of its financial assets (working
capital, reserves, endowment)
third party collateral or guarantees
The basic security structure of a revenue bond issue is typically
augmented by a series of covenants, all articulated in the major bond
documents (indenture, loan agreement, etc.). Those covenants are
designed to foster prudent management and financial performance and
to establish minimum acceptable standards in that regard. Examples of
such covenants include the following:
à
à
à
à
à
à
à
rate (or revenue) covenant
liquidity covenant
maintenance of reserves and endowment above certain
minimum levels
delivery of financial information on a timely basis
limitations on additional encumbrances
limitations on additional debt
limitations on the sale or disposition of major assets
For a school with outstanding debt, crafting the security structure can
be particularly challenging. Sometimes the terms of the outstanding
debt expressly allow additional debt, but on terms which are not feasible
or acceptable. In such instances, it is not uncommon for the school to
refinance or “defease” such earlier debt in order to secure covenant
relief or to release the security of that debt in favor of the transaction at
hand.
ƒ
Interest Rate Modality: The two basic options for a borrower with
respect to interest rate are (1) fixed and (2) variable. The level of fixed
rates available to a tax-exempt borrower will be a function of (1) the
term of the debt and (2) the credit ratings of the transaction, or in the
absence of credit ratings, the perceived credit quality of the borrower
versus others in the non-rated sector of the market. Fixed rates in the
tax-exempt market are in turn driven by such factors as (1) taxable
yields, particularly those for U.S. Treasury obligations, (2) the marginal
income tax rates for individual and institutional investors and (3) the
relative levels of supply and investor demand for tax-exempt
obligations.
A period of sustained economic difficulty and large U.S. government
deficits from the late 1960s through the early 1980s caused interest rates
in all domestic markets to rise to double digit levels. The period from
1982 to early 2000 witnessed a general decline in interest rates,
punctuated by periodic increases. By June, 2003, interest rates in the
domestic debt markets had reached a nearly 40 year low point. In the
22
early 1980s, in response to unaffordably high fixed interest rates, the
investment banking community developed a variable rate financing
technique called variously “low floaters”, “floating rate bonds” and
most commonly, variable rate demand bonds (“VRDBs”).
Overview of VRDBs
œ Low Rate – In exchange for highly secure credit quality and liquidity, and a
put right supported by a bank letter of credit, investors in VRDBs are willing
to accept yields which are usually significantly lower than long term fixed rates.
œ Interest rate – Reset daily, weekly, monthly, semiannually, annually (in some
cases a commercial paper structure is possible).
œ Liquidity Facility – At a minimum, VRDBs must be secured by a highly
rated bank letter of credit which provides “liquidity” that guarantees investors
repayment of their investment on an interest rate reset date if they “put” their
bonds.
œ Credit Enhancement – More often, a letter of credit provides long term
credit enhancement as well as short term liquidity. With credit enhancement, a
bank unconditionally guarantees repayment of a defaulted bond.
œ Remarketing – On each interest rate reset date, a remarketing agent
renegotiates the interest rate on VRDBs on behalf of the borrower.
œ The Market – VRDB interest rates are first and foremost driven by supply
and demand in their own market and secondarily by conditions in the
economy and taxable debt capital markets. The “BMA Index” is an industry
average, published daily, of the interest rates on outstanding VRDBs.
Interestingly, despite the relatively low fixed interest rates available to
tax-exempt borrowers in recent years, many governmental and nonprofit borrowers, including private schools, have continued to opt for
variable rate financing. The reasons for using VRDBs have been and
continue to include the following:
ƒ
à
potential to realize significant interest cost savings versus
the fixed rate alternative, thereby making a project more
affordable or increasing the school’s borrowing capacity,
à
“flexibility” in the respect that VRDBs can be repaid
partially or fully at any time without the type of early
redemption protection or prepayment penalties typically
associated with fixed rate bonds,
à
potential for lower costs of issuance, although in recent
years, the relative costs of issuance for fixed rate bond
issues have declined appreciably.
Credit Enhancement: The two types of credit enhancement used
most commonly in the tax-exempt bond market are letters of credit and
bond insurance. Bond insurance and an “unconditional” letter of credit
23
are used to assure investors the repayment of principal and any unpaid
interest due on a bond issue which has defaulted. The practical effects
of deploying credit enhancement are to give the borrower access to a
segment of the bond market otherwise unavailable (eg. the VRDB
market, investment grade only mutual funds) or to lower the borrower’s
overall interest cost. Generally, banks will offer letters of credit only for
fixed periods of three to seven years. Consequently, they are only
available for use with VRDBs. Bond insurance can be used both for
VRDBs (although a line of credit would also be required for the
liquidity requirement) and fixed rate bonds. The cost of credit
enhancement can be fully capitalized in a tax-exempt bond issue.
However, there must be a demonstrated “net savings” in debt service as
a result of its use. Calculations demonstrating such savings net of the
cost of the credit enhancement can be provided by a financial advisor.
Although the credit ratings of banks which provide credit facilities for
VRDBs range widely within the investment grade rated sector, the
credit ratings of most of the major bond insurance companies (MBIA,
FGIC, AMBAC) are “AAA”.
For the most part, bond insurance companies seek to enhance private
schools already capable of securing an investment grade credit rating.
Consequently, bond insurance would not be available to most private
schools. Notably, one lower rated (“A”) bond insurance company
(FSA) has provided bond insurance for non-investment grade quality
schools in limited instances.
In recent years, bank letter of credit providers have been decidedly more
lenient than the major bond insurance companies in their credit criteria
for private schools, particularly schools located in the bank’s service
area. Unlike bond insurance companies which provide a one-time
service for a one-time premium, banks in most instances seek a broader
relationship with their customers and will look to marry a credit facility
with bond underwriting and remarketing services, a checking and
depository relationship and investment management support.
ƒ
Derivative Products: “Derivatives” are versatile financial instruments
which can be used in asset or debt management or with respect to a
debt financing to achieve a specific financial objective or to limit the
user’s financial risk. Examples of derivative products include:
à
à
à
à
interest rate swaps
interest rate caps
interest rate collars
swaptions
24
Overview of Swaps
œ
œ
What is a Swap? An interest rate swap is an agreement to:
3
Exchange a floating interest payment for a fixed interest payment
3
Based upon a specific notional principal amount
3
For a defined time period
3
Tax-exempt floating rate is driven by variable rate bond market (usually BMA Index)
How can a swap be used?
3
Interest Rate Management
ƒ
Adjust the duration of assets or liabilities to reflect the borrower’s interest
rate management strategy
3
Enhance Asset Yield
ƒ
Create synthetic fixed or floating rate assets with higher yields
3
Arbitrage
ƒ
Capitalize on relative inefficiencies between two markets
3
Lock Interest Cost
ƒ
Create “synthetic” fixed rate debt for a specific period
ƒ
Eliminate interest rate risk for future floating rate debt
ƒ
Structure a synthetic advance refunding
3
Asset/Liability Management
ƒ
Achieve the desired balance sheet match of fixed rate or variable rate assets and liabilities
Interest Rate Swap Example
œ Borrower has an outstanding long term variable rate bond issues and desires to fix interest cost on its
borrowing for the next five years.
œ Borrower enters into a five year Interest Rate Exchange Agreement with a highly rated financial institution
under which the Borrower pays a five year fixed rate (eg. 3.5%) and receives a variable rate payment.
œ Borrower continues to pay the weekly floating rate, annual letter of credit and remarketing fees on its
outstanding variable rate bond, and either pays or receives the net difference between the fixed rate and
BMA.
œ Total approximate annual interest cost = 4.75% (assumes 1.25% for remarketing and letter of credit fees).
Fixed
L.C. & Remarketing Fees
(1.25%)
L.C.
Bank
Swap
Client
Swap
Counterparty
Variable (1.5%)
(BMA)
Variable
(1.5%)
Variable
Rate
Bondholders
Floating Rate Received on Swap
Floating Rate Paid on Bond Issue
Letter of Credit Fee on Bond Issue
(estimate for next 5 years)
Remarketing and other Fees on Bond Issue
Fixed Rate Paid on Swap
Total Effective Cost
+ 1.500% (BMA)
- 1.500% (assumes current weekly rate is 1.5%)
- 1.125%
- .125%
- 3.500%
4.750%
25
Derivatives have a provocative reputation because of well publicized
episodes in which they were deployed by major borrowers that either
did not understand or ignored the financial risks associated with these
financial instruments. Used properly and on a fully informed basis,
derivative products can help a school tailor the debt service of a bond
transaction to its budgetary constraints and within its tolerance of risk.
It has not been uncommon for banks to encourage or require the use of
an interest rate swap to “hedge” a school against interest rate risk in a
VRDB issue. A school considering such a proposal is well advised to
consider (1) the necessity of such a hedge, (2) the term and risks of the
proposed swap and (3) whether it is an absolute condition of the
issuance by a bank of the letter of credit. In any case, securing an
interest rate swap or any other derivate product should be done through
an open, competitive bidding process. The interest rate swap market is
complex and inefficient and schools should not enter it without the
benefit of a thorough understanding of its risks, mechanics and costs.
D. Financing – Structuring Phase
The outcome of a school’s financing in terms of timeliness, transaction cost and
cost of capital will be driven in large part by the quality and thoroughness of
planning throughout the financing process. At the structuring phase, the school
will focus on the following details working closely with its legal counsel, financial
advisor and underwriting/banking professionals:
ƒ
Financing Timetable
ƒ
Bond Issuance Process
– Issuer application
– Issuer review and approval
– Required hearings
ƒ
Bond Issue Structure
– Term
– Interest Rate Modality
– Credit/Security Structure
– Credit Enhancement
– Credit Ratings
ƒ
Key Information Requirements
– Audited Financial Statements
– Financial Projections
– Material Information About School, Management and Project
ƒ
Bond Marketing Process
– Private Placement
26
–
Public Offering
ƒ
Credit Rating/Credit Enhancement Process
– Presentations
– Confidential Consultations
– Bond Insurance Companies (Fixed Rate Bonds)
à Bond Insurance
à Reserve Fund Surety
– Letter of Credit Banks (VRDBs)
à Term Sheet
à Commitment Letter
ƒ
Transaction Documents
– Bond Indenture or Trust Agreement
– Financing (Loan) Agreement
– Bond Offering Document/Disclosure Matters
à Private Placement Memorandum
à Official Statement
– Bond Purchase Agreement
– Issuer and Borrower Certifications
– Real Estate Legal Documents
Typically, the professionals representing the underwriter or bank in a transaction
take the lead in managing and orchestrating the structuring process for a
financing. Borrower’s counsel and financial advisor should play an active role in
representing the school to assure generally that the school’s legal and financial
interests are protected and specifically that the transaction is being structured and
implemented on terms and at a cost consistent with the underwriter’s or bank’s
proposal. A “working group” comprising the school’s chief representative(s)
(president, chief financial officer, business manager), school legal counsel and
financial advisor, bank/underwriter and counsel and bond counsel will
collaborate in the development and review of the transaction documents until
they conform optimally with the school’s finance plan and preferred financing
structure. Generally, the documentation process will occur over a six to twelve
week timeframe depending on such factors as the complexity of the transaction,
bond issuer requirements and number of individuals involved in generating and
revising the documents. For any capital markets-oriented transaction, the
culmination of all of the efforts of the working group during the structuring phase
will be final drafts of all of the basic transaction documents and either a Private
Placement Memorandum (PPM) or a Preliminary Official Statement (POS) to be
used in the offering and sale of the bonds.
E. Financing – Execution Phase
The process for marketing bonds and finalizing pricing (interest rate and fees)
varies depending on the type of financing (fixed vs. variable rate) and if a fixed
rate public offering, whether the bonds have investment grade credit ratings.
27
Accordingly, the following is a brief overview and comparison of the process for
each of those scenarios.
ƒ
Variable Rate Demand Bonds: The initial offering and sale of VRDBs
has become a highly mechanical process. The vast majority of VRDB
investors are institutions, primarily mutual funds and insurance
companies. The marketplace is deep and efficient. The interest rate on
the bonds is driven primarily by (1) the short and long term credit ratings
of the letter of credit provider and (2) the interest rate adjustment period,
and secondarily by (3) the efforts, reputation and expertise of the
underwriter/placement agent. Typically, the offering document for
VRDBs is distributed three to ten days before pricing, and the VRDBs are
all priced and sold within one day with closing scheduled within a week
after sale.
ƒ
Fixed Rate Bonds – Rated: Over the past decade, information and
telecommunications technology has streamlined and compressed
significantly the offering and pricing process for credit rated fixed rate
tax-exempt bonds. Although underwriters will still make a POS available
in printed form, the market is migrating to a primarily electronic based
system of information dissemination, with the POS, for example, being
distributed via email to prospective, qualified investors. The overarching
factor impacting the interest rate or rates ultimately established for the
debt is the credit rating level of the bonds. Still, the efforts of individual
professionals interacting with the investment community are important
and integral to that rate setting process. The bankers, underwriters,
traders and investment sales representatives of the school’s underwriting
team play an important role in educating candidate investors about the
school and its transaction and securing orders from such investors.
Ultimately, the final rates on the bonds are established when the
underwriting firm has adjusted the rates on the bonds to a level which
achieves a reasonable but not excessive level of investor subscription. At
that point, the underwriter will present a formal offer to the school to
purchase all of its bonds at specific rates, reoffered yields and prices.
During the execution phase of the financing, the school’s financial advisor
should be playing an active role monitoring the underwriter’s efforts to
assure high quality and focused service and “on the market” (ie.
competitive) pricing of the bonds. Once the school and underwriter have
executed a Bond Purchase Agreement, the school has “locked” in its
interest cost on its debt. Typically, fixed rate bonds settle within two to
three weeks of execution of the Bond Purchase Agreement.
ƒ
Fixed Rate Bonds – Non-Rated: Of approximately 30,000 independent
schools in the United States, approximately 70 currently have investment
grade credit ratings5. Although more could secure such ratings based
5
Based on credit ratings provided by one or more of the major rating agencies as of January, 2005. Does not
include ratings issued for transactions which included a bank letter of credit or bond insurance.
28
upon their financial statements and the rating agencies’ rating criteria, the
vast majority of independent schools in the U.S. are not of investment
grade quality. In past times, absent a credit rating or credit enhancement,
a school would likely not have access to the fixed rate capital markets.
However, as the intermediaries and investors in the tax-exempt bond
market have become increasingly familiar with the independent school
sector, they have become more receptive to school transactions which are
non-investment grade but still “good stories”. The market’s relative
enthusiasm for non-rated private school bonds is in no small part driven
by the fact that there has never been a reported, uncured financial default
of a private school bond issue in the United States. This interesting
statistic is testament to the quality of stewardship and stakeholder support
which private schools enjoy.
29
CREDIT QUALITY
AND
RATINGS
Credit quality can be measured both on an absolute basis and on a relative basis. On an absolute
basis, credit analysts look at the school and its market area to form a judgment about
creditworthiness. Key areas of inquiry are summarized below.
Key School Performance Factors
œ Market Position
3
Historical enrollment trends and target size
3
Selectivity and yield (matriculation) rates
3
Geographic diversity
3
SAT/ACT scores of graduating students
3
Secondary school and college placement of graduating students
3
Retention Rates
3
Trend of net tuition per student, and future pricing plans
3
Cross-admission (win/loss) data versus primary competitors
œ Financial Resources
3
Balance Sheet strength
3
Liquidity/Capital Reserves
3
Fundraising
œ Operating Performance
3
Operating Margin
3
Annual Debt Service Coverage
3
Revenue Diversity
œ Debt
3
Debt Capacity
3
Outstanding Debt
3
Term of Proposed Debt
œ Management
3
Budgetary/Monitoring Practices
3
Board Composition/Involvement
It is the rare school whose circumstances are so distressed that it cannot incur and support some
level of debt. Many schools have no practical alternative to debt in order to address mission
critical facility needs on a timely basis. The challenge for each school is to determine how much
debt it can afford and on what terms. An application of typical credit rating agency financial and
operating ratios to the school’s LTM (last 12 month) financial statements and next three to five
year financial projections is a proven and effective way to begin to triangulate a debt capacity
range. A financial advisor can also play a helpful role in such analysis and provide a formal
opinion and supporting debt capacity analysis to help a school’s board and management assess
the school’s financing prospects and to determine prudent limits on the amount and type of debt.
Many schools develop a Debt Policy to use as a device to maintain a stable financial position and
remain in good standing with their investors and lenders.
30
All schools are well served familiarizing themselves with the key credit rating criteria and
integrating such criteria into their strategic planning, budgetary and financial management
processes. Moreover, those schools with strong performance metrics considering debt financing
should consider pursuing credit ratings in connection with such financing regardless of whether
fixed or variable rate financing is contemplated. In the case of a VRDB financing, either a
published or “shadow” rating can be an effective tool in negotiating the most favorable terms
and price for a letter of credit and any type of interest rate hedge.
For a fixed rate financing, the credit rating will be the single most significant determinant of the
interest cost on the debt. Despite the variability of income taxation on a state by state basis, the
tax-exempt bond market is very efficient in correlating yield to maturity and investment grade
quality. Consequently, through a preliminary, confidential assessment of a school’s likely credit
rating level, and an analysis of the pricing of recent comparably rated transactions, a school
should be able to determine what its cost of capital in a fixed rate issue would be at the time
within 10 to 15 basis points (.1 to .15%). A school whose finances and proposed transaction
appear to qualify for an investment grade credit rating should concurrently explore the availability
and cost of bond insurance. If bond insurance is available at a sufficiently low price, the bonds’
credit ratings can be raised to “AAA” rated quality.
At the present time, there are three nationally recognized credit rating agencies which provide
rating assessments of tax-exempt bond issues: Moody’s Investors Service, Standard & Poor’s
Corporation and Fitch Investors Service. Each of these agencies maintain relatively similar
criteria, conduct comparable credit assessment reviews and publish credit ratings which attempt
to relate on an absolute and relative basis the financial security of a particular transaction. The
following rating scale of Moody’s Investors Service is representative of the categories of credit
quality:
Rating
œ
œ
œ
œ
Aaa*
Aa1,2,3*
A1,2,3*
Baa1,2,3*
œ Ba1,2,3
œ B1,2,3
œ Caa to C
Financial Security
Exceptional
Excellent
Good
Adequate
Moderate
Weak
Default
* Investment Grade
Source: Moody’s Investors Service
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The following are select median financial and operational ratios and benchmarks for high
investment-grade through low and non-investment grade independent school credits6. (Note:
Each of the three rating agencies referenced above has slightly different rating guidelines and criteria. Current and
detailed rating criteria for each of these rating agencies are available upon request.)
Median
Aaa
Aa
A
Baa
Below
Baa
Capital Ratios:
Unrestricted financial resources-to-direct debt (x)
Expendable financial resources-to-direct debt (x)
Total financial resources-to-direct debt (x)
Total cash & investments-to-direct debt (x)
3.49
6.62
8.87
8.67
2.69
3.10
5.18
4.91
1.33
2.04
2.79
2.66
0.76
1.00
1.20
1.64
0.30
0.34
0.99
1.01
Balance Sheet Ratios:
Unrestricted financial resources-to-operations (x)
Expendable financial resources-to-operations (x)
2.53
7.71
2.48
3.07
1.62
2.08
0.63
0.73
0.32
0.43
7.8
22,348
9.4
0.9
10,290
2.3
0.9
4,958
1.8
1.0
3,454
2.3
-4.5
4,918
1.5
Contribution Ratios (% of Total Operating Rev.):
Net tuition and fees (%)
Auxiliary enterprises (%)
Investment income (%)
Gifts (%)
Other (%)
26.3
10.8
44.7
11.9
3.0
40.8
12.6
29.3
7.7
2.3
52.2
9.1
12.8
9.6
1.7
73.2
5.6
5.9
10.2
2.8
62.3
2.9
5.5
6.4
1.1
Market Data and Ratios:
Selectivity (%)
Matriculation (%)
27.2
66.8
30.4
63.9
45.3
70.6
54.4
59.9
78.0
67.1
Operating Ratios:
Annual operating margin (%)
Total gifts per student ($)
Actual debt service coverage (x)
6
Source: Moody’s ‘Independent School Outlook & Medians 2004-05’ dated August, 2004. Data based on fiscal
year 2003 reported financial data and fall 2003 reported enrollment data.
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HOW AN INDEPENDENT FINANCIAL ADVISOR CAN HELP
A knowledgeable and experienced financial advisor can play a crucial role in assisting a private
school to secure the most favorable financing, and to maintain its financial integrity on an
ongoing basis.
Wye River Group is a specialty financial advisory firm focused on providing advisory services to
not-for-profit institutions and state and local governments and agencies. Our range of capability
includes the following:
3 Capital Analysis and Planning
ƒ Financial Modeling
ƒ Financial Projections
ƒ Debt Affordability Analysis
ƒ Credit and Credit Rating Assessment
ƒ Debt Policy Development
3 Debt Financing Support
ƒ Evaluation of Financing Options
ƒ Finance Plan Development
ƒ Competitive Solicitation of Debt Financing
ƒ Rating Agency/Credit Enhancement Presentations
ƒ Debt Structuring & Implementation
ƒ Arbitrage Calculations & Reports
ƒ NRMSIRs Reports/Annual Reports
3 Investment Counsel
ƒ Structured Investment of Debt Proceeds
ƒ Cash Management
ƒ Reserve/Endowment Asset Allocation Services
To serve the needs of our clients, our Firm’s professionals draw on more than 100 years of
combined experience as financial advisors, investment bankers, attorneys, educators and federal
government executives. Wye River Group’s professionals have completed more than 250 debt,
lease and related transactions totaling over $10 billion during their collective careers.
Because many of our not-for-profit clients have not previously issued debt or have modest
financial statements, our professionals’ credit expertise can be integral to a successful financing
effort. With backgrounds in bond finance and law and credit rating analysis, Wye River Group’s
professionals have considerable experience in assessing the creditworthiness of non-profit
organizations and then assisting such organizations to best position themselves for a debt
financing.
Our fixed and variable rate financing solutions are designed to meet the unique needs of each
not-for-profit borrower. Many non-profit institutions receive gifts and grants that help to insure
their long-term viability. These funds can be structured to help support a bond financing, often
without any direct security pledge by the institution.
33
Some financings for non-profits require discrete private placement or limited institutional
underwritings because investment grade credit ratings may not be achievable. With its extensive
experience in low and non-investment grade credits, Wye River Group is well equipped to
structure financings for institutions with limited market access.
Good planning and strong, independent financial advice are musts for any school contemplating
or undertaking a capital financing.
7 King Charles Place
Annapolis, Maryland 21401
Ph: 410.267.8811
Fx: 410-267-8235
www.wyeriver.net
Kevin G. Quinn
Robert F. Doherty
Thomas J. Street
Christopher O. Wienk
34